The conventional monetary theory is that when you increase the stock of money, you increase the nominal value of everything in the economy. For example, if you had a given quantity level of money, and you had a house worth a hundred grand, doubling the quantity of money results in everything doubling in price, including your house, which is now worth two hundred grand. You are nominally richer now, though in real terms, you’re just the same as before, because everybody in the economy now has double the money they had before.

So the theoretical basis for QE2, which is buying long-term bonds held by the private sector, is to take away their savings vehicle and exchange it for money. Since everyone now has more readily spendable money than before, and because they are now concerned that this will result in a higher price level for goods and/or a depreciation in real value for their money stock, the idea is that this causes everyone to charge out of holding money and exchange it as fast they can into actual goods. In other words, doubling the stock of money will get people to spend their new money as fast as they can.

But Is there a sizeable number of private households that own government bonds, and have a sizeable demand for money for transactions? Aren’t people who buy long-term bonds those who are saving up for retirement and therefore will not sell the bond prior to retirement? Those who may suddenly need money for transactions never buy long-term bonds. There’s too much duration risk and they may end up selling when bond prices are down.

The only agents who buy long-term bonds and who also may have a sizeable demand for money for transactions remain the banks. That’s why banks don’t solicit individuals/households to buy TSecs from them. There’s just not much of them.

Also, even if there were a few who do, at some tradeoff point, selling may indeed become more advantageous to holding bonds. And any households that do (if they can theoretically sell bonds to the Fed, via banks) will probably save the proceeds in alternative ’savings’ investments like equities and commodity funds. They’re not likely to spend their retirement savings on consumption.

People putting money into equities and commodities does not necessarily increase their nominal expenditures, and definitely does not in itself reduce unemployment. Nominal asset values may have increased, but increased expenditure by a majority of people need not follow. Not if new income wasn’t created.

Increase in nominal asset values reduces the burden for existing borrowers, but it certainly INCREASES the burden for new borrowers. So how are new businesses, and new employment going to be created? How does this increase demand for credit, which is the channel for new money created by the Fed to go out into public circulation? Though quantitative easing may strengthen balance sheet of banks, increasing nominal asset values does not increase the number of creditworthy borrowers.

So this new money does not necessarily go directly to those in need of money for immediate transaction. If you ask people who truly needed money for capital investment in the first place, they would have sold any government bonds they had without need for more monetary easing. In fact, the easing, and the resulting higher nominal price level, may have only made the cost of their needed capital investment more prohibitive.

Does increasing money stock lead to increasing velocity

MV=PQ. The conventional monetary theory is that if you increase the stock of money, this increases the price level, holding everything else constant. Further, if you increase the money stock, this causes people to not want to hold on to money, passing it along like a ‘hot potato’ to the next spender by quickly spending it before it loses value (due to inflation).

But the end result could just as well be a decrease in velocity. The resulting high prices could just be that the increasingly few transactions are clearing at the ever increasing price. If the money stock keeps increasing, this supports an increasing price level even though the velocity and the volumes may already be decreasing.

For example, take a look at this statement: “If everybody 'tries' to sell more money they will succeed in doing so. They can’t, in total, get rid of money by selling it, if the total amount is fixed, because it just goes from one person’s pocket to another person’s pocket. But they ‘can’ still sell more, even if everyone else is trying to sell more. They buy output and labour from the unemployed, who are only too happy to “buy” that money in exchange for their labour.”

Completely logical from the point of view from a monetarist. But how about we turn this statement around, to look at it from the other side - the side not of people trying to get rid of money, but of people trying to hoard goods and services.

It becomes something like this: If everybody ‘tries’ to BUY more money they won’t succeed in doing so. They can’t, in total, get rid of LABOUR AND OUTPUT by BUYING MONEY, even if money’s total amount is increasing, because money just stays in a few people’s pocket. But they 'can' still BUY more labour and output, even if everyone else is trying to BUY more of it. They SELL MONEY TO the unemployed, who are only too happy to “SELL” LABOUR AND OUTPUT in exchange for their MONEY.”

We didn’t change change the implications of the statement, we only changed the viewpoint. But now it makes sense to think of increasing money as not necessarily resulting in inflation. It may just end up lowering people’s value for goods and services, labour and output. Hence, it can lead to a deflation and/or recession. It can lead to less transactions. It can lead to less velocity. Less people trying to get rid of goods and services, labour and output.

Does higher money velocity lead to a higher price level

In the same vein, the same stock of money flowing more quickly should not in itself lead to higher price levels unless people are bidding up the prices while getting rid of money. But people can only bid higher if they already have more money to pay with. This necessitates a growing money stock. But how do people get to more money? By earning it or by borrowing it. Whether you earn it or you have to borrow it, sufficient income prospect is the more important consideration than increasing nominal values. But higher nominal values will only happen AFTER people already have in their hands the higher money stock level to buy more dearly with, not when it's still in banks as newly-created reserves.

15 comments:

Thanks, Mario. Unfortunately this comment just went over the heads of many commenters at Money Illusion.

Many people over there don't believe in the existence of banks or debt, and think that increasing the money supply automatically results in a higher price level.

Those that do believe in the existence of banks think that banks automatically lend what funds land on their laps without consequence. And that they can just find additional capable borrowers out on the street like Mcdonalds finds new patrons for new stores.

"Many people over there don't believe in the existence of banks or debt, and think that increasing the money supply automatically results in a higher price level."

It's actually funny too b/c what they are really saying is they don't believe in the law of supply and demand for actual goods and services...they are overly focused on the supply side of dollars in the economy that they fail to actually understand supply/demand functions in the economy. It's rather humorous in fact...or really sad considering how pervasive it is.

"And that they can just find additional capable borrowers out on the street like Mcdonalds finds new patrons for new stores."

Well that was rather accurate just a few years ago. Not that "having more funds" had anything to do with it of course...it was a legal loophole allowance not a funding increase. ;)

Question for you:

why is bank created money any different from government created money? B/c banks can default on their loans, right? So doesn't this mean then that until those defaults occur really the bank money is no different than government created money? I am trying to really see the difference between horizontal and vertical money. I know the idea that for the borrower the loan is an asset and for the lender it is a liability, but why does that matter exactly? It doesn't "cross cancel" the fact that money was created (money supply increased). All I can think of is that it just means that money could be defaulted on (or essentially un-printed + possible micro insolvency for that lendee and possibly for lender too if at a mass scale). So really the only difference between horizontal and vertical money is that horizontal money is just more risky. Right?

Yup, a loan is riskier, and eventually gets unprinted when it's paid back.

Also, since it has to be paid back, needs a creditworthy borrower that will have the income to pay it back. Government spending, as far as I know, never has to be paid back if it was paid for services rendered.

"Yup, a loan is riskier, and eventually gets unprinted when it's paid back."

one thing that is interesting with China is they seem to be using government banks to do the government spending by simply allowing the loans to default. Interesting variation on the theme of centrally planned government I'd say.

It becomes something like this: If everybody ‘tries’ to BUY more money they won’t succeed in doing so. They can’t, in total, get rid of LABOUR AND OUTPUT by BUYING MONEY, even if money’s total amount is increasing, because money just stays in a few people’s pocket. But they 'can' still BUY more labour and output, even if everyone else is trying to BUY more of it. They SELL MONEY TO the unemployed, who are only too happy to “SELL” LABOUR AND OUTPUT in exchange for their MONEY.”

We didn’t change change the implications of the statement, we only changed the viewpoint. But now it makes sense to think of increasing money as not necessarily resulting in inflation. It may just end up lowering people’s value for goods and services, labour and output. Hence, it can lead to a deflation and/or recession. It can lead to less transactions. It can lead to less velocity. Less people trying to get rid of goods and services, labour and output.

I might be misunderstanding it too so Rogue might be able to explain it better than me, but the way I read it is that it's basically showing that people and labor trumps money always.

Think of it like you would an auction for example. One party is buying and one party is selling.

Employees buy money and sell their work (output).

Employers buy work (output) and sell money.

The paragraph is proving that a society cannot sustainably and reasonably exist where employers perpetually sell their work (output) and buy money (ie lay people off essentially). The reason is b/c of the fact that people trump money. Widespread selling of labor means high unemployment and it also means a large concentration of capital in the hands of a few. It's not a sustainable scenario and cannot go on forever. Either the economic mind changes or the body politic changes (aka revolution, revolt, evolution, changing of the guards, etc.).

rogue, the one thing I'm not clear on is that when an employer sells work and buys money, the total aggregate level of money stock doesn't change. It's just re-distributed. So to connect that money stock isn't exactly accurate unless they are paying people through bank loans perhaps. Am I missing something?

Dan, sorry for the confusing paragrapah. I had meant it as a complete mirror image of Nick Rowe's point, where he tries to show that increasing money supply makes it like a hot potato where everybody tries to get rid of it by buying. I was saying that increasing money supply doesn't necessarily make it a hot potato if a lot of people are jobless. It just makes them accept lower wages than before, which doesn't improve the demand situation, because low wage people will just buy basic necessities and the capitalists who earn more may just save whatever they can. Mario's understanding is close to my point.

Mario, yes, I was implying to Nick that people will get to the higher money stock created by monetary easing only by borrowing it. But he seems to imply that the higher money stock automatically leads to higher price level. I asked him if it was helicopter money, and he said it could be. So that's a concession from him that he acknowledges fiscal policy is what really gets the money directly to the users.

yes makes sense now. I see what you're saying. Increasing money supply wouldn't raise prices until a threshold was breached at the level of goods purchased such that the seller found a greater opportunity cost to raising prices (time, labor, etc.). The money supply can continue to increase up to that point without inflation, and that point, as you say is greatly, if not solely, determined by how much extra income the buyers have. I think it's also worthy to note that this "water-level" for higher prices is different for each product/good being offered (necessities have more buyers than luxuries so theoretically they will see a change in price sooner than luxuries) as well as the environment and community those goods are being offered in (a community with more disposable income will have higher prices for the same/similar goods/services than a poorer community for example). B/c of these factors, so much is relative when it comes to inflation that sometimes the CPI numbers are misleading in more ways than one. And attempting to "define" the rate of inflation almost becomes futile if not at least highly relative or very general.

Couldn't a larger exporting sector increase the money supply as well as that would be considered "new money" entering in to the economy?

Couldn't a larger exporting sector increase the money supply as well as that would be considered "new money" entering in to the economy? "

yes, but this would largely be money that they can largely use to buy the trading partner's goods. If you convert it to your local currency, your currency will go up, and that's the end of your exporting prowess.

Don't we now see that countries would prefer a race to the bottom in depreciating their currencies vs losing their export competitiveness?

"Don't we now see that countries would prefer a race to the bottom in depreciating their currencies vs losing their export competitiveness?"

it does appear to be that way and interestingly an Austrian/Libertarian would seemingly favor such "private enterprise" versus "government intervention" to boost an economy. Which funnily enough only brings on the very inflation that they were so concerned would come from government/fiat helicopter money.

The ironies today in the realm of economics are so rampant. The writer/director of this show must be laughing his you-know-what off!

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.